Most borrowers are familiar with the concept of a “secured” loan. A secured loan is a loan that includes a lender holding legal title to a piece of collateral until the borrower repays the loan. When the borrower repays the loan, legal title to the collateral reverts to the borrower. A common form of property purchased under such terms is an automobile. A similar transaction is a lease transaction in which a lessor holds legal title to property during the term of the lease. When the lessee completes the lease obligation, the lessee generally has an option to purchase and own the property. Again, a common type of property purchased under such terms is an automobile.
In a common automotive loan, the lender pays the sale price to the seller of the automobile and holds legal title to the automobile. The borrower has equitable title to, and physical possession of, the automobile. Thus, the automobile is the collateral on the loan. The borrower repays the lender on a predetermined schedule that typically includes interest charged over the life of the loan. Leases work in a similar fashion, except that equitable title does not exist. The transaction is similar to a “rental” agreement for a specified term. Generally, the lessee will have the option to purchase the property at the culmination of a lease arrangement.
In either case, if the borrower defaults on the loan or lease agreement, i.e. fails to uphold the loan or lease agreement, the lender or lessor has the right to repossess the collateral, i.e. gain physical possession of the automobile. The lender then disposes of the collateral to recoup as much of the loan balance or property value as possible. It is not unusual, however, that the amount recouped is much less than the loan balance or expected property value, often due to damage to the automobile.
In most respects, the borrower treats the collateral or lease property as his or her own. In fact, most, if not all, secured automobile loans and leases require the borrower to maintain a minimum level of insurance against damage to the automobile. That is, the lender has an interest in making sure that the collateral is in good condition because, should the collateral be damaged, the lender would be even less likely to be able to recoup the loan balance or expected property value in the event of a default. The consequence of the borrower not maintaining insurance, however, is not always uniform. As a general matter, so long as the borrower is repaying the loan, the bare fact that the borrower has not maintained insurance may not be enough cause for most lenders, to repossess the collateral. The decision is purely a matter of risk management style though.
Nevertheless, the lender or lessor, in most cases, must take some steps to protect itself from the effects of damage to the collateral or lease property. Some lenders and lessors maintain a “blanket” insurance policy covering all collateral on all secured loans funded. Claims are submitted to the insurer when the lender or lessor becomes aware of damage to its collateral or lease property, usually upon repossession and just prior to asset liquidation. Typically, none of this blanket premium cost is passed on to borrowers.
One drawback to this method is that the blanket insurance policy has been maintained on all the collateral or lease property within the portfolio, without regard to whether the borrower or lessee maintained insurance on the collateral. Generally, the premiums paid for the blanket insurance is typically much greater than the claims paid for damage to the collateral. A typical ratio of claims recovered to premiums paid runs between 50-75%.
An alternate method known in the prior art is “force-placed” insurance. The force-placed method tracks the insurance activity within a lender's or lessor's portfolio to ensure that insurance coverage has remained in place. If a borrower's or lessee's insurance has lapsed, a notice is sent out to the borrower reminding the borrower or lessee to obtain coverage immediately. If the borrower or lessee fails to comply, the lender or lessor purchases an insurance policy and adds the insurance premium to the borrower's loan balance or lease requirement.
The drawback of this method is that it is expensive to the borrower or lessee, since premiums often run to 14-18% of the loan balance, and to the lender or lessor, since much of these premium amounts will be uncollectible from the borrower or lessee and will, consequently, need to be paid to the insurance company by the lender or lessor.
Another drawback to this method is that many borrowers and lessees have been confused by the limited benefits of such force-placed insurance policies and assume that the benefits of the borrower's or lessor's insurance and the benefits of a force-placed policy are the same. In fact, the coverage is usually limited to collision coverage, primarily to protect the lender's or lessor's interest in the collateral or lease property. In other words, the premium for the force-placed insurance policy is relatively high and is paid by the borrower or lessee with the primary benefit to the lender or lessor. As a result, a number of complaints and lawsuits regarding the disclosure required to inform the borrower or lessee of the limitations of force-placed insurance policies have made some lenders and lessors wary of such a method. Nevertheless, many lenders and lessors still use this method widely in the industry.
Another method used on a very limited basis is a fee assessed to every borrower or lessee that applies for a loan or lease. Typically, this fee is assessed at the time of the loan or lease. The drawbacks of this method include: (a) all borrowers or lessees are required to pay the fee without regard to whether the borrower or lessee maintained the required insurance and (b) the fee is assessed at the beginning of the loan or lease rather than at the time of, and upon the condition of, the lapse or impairment of insurance. Thus, this method is unfair to borrowers who abide by the terms of the loan agreement. This method is also likely to cause the lender or lessor to become uncompetitive in the marketplace.
It can be seen, therefore, that there is a need in the art for a new method and system for protecting collateral in a secured loan.